VALUING NGMOCO - PART 2 - REVENUE (FROM DAN ROGERS'S LAW BLOG (DLR-LAW.COM)

Money…bum ba da dah.
Get back.
I'm all right, Jack.
Keep your hands off my stack.

When trying to understand video game acquisition logic, Pink Floyd knows what to look for.  Cash. Bread. Quid. Dinero.  Acquisitions are motivated by the prospect of earning money. 

The logic behind a revenue-motivated purchase is simple, but the implementation is anything but. Public companies are rewarded for increasing revenue. So a video game company is theoretically interested in purchasing another entity if in doing so the outcome results in either increased revenue or lower costs. Both approaches increase profit.  

So, how do you increase revenue?  One way is by purchasing a company that has a product you can exploit using your corporate strengths. In the video game industry, this muscle is typically a strong sales channel and marketing expertise, and in both EA is a leader. Electronic Arts, because of its size and strength, is a publisher with the ability to exploit good product, and a lot of it.  This was likely their thinking when they purchased Bioware/Pandemic in early 2008 from Elevation Partners. 

In EA’s 2008 Annual Report, the Bioware/Pandemic assets are itemized as follows:

  $   68        Current assets 
  $     8        Property and equipment, net  
  $ 138        Acquired in-process technology
  $ 414        *Goodwill  
  $ 114        *Finite-lived intangibles  
  $    9        Long-term deferred tax  
  $  (69)       Other liabilities 
           
  $ 682        Total purchase price (MILLION )

There are a couple of things to note here.  First, Finite-lived Intangibles are assets that have a lasting value, such as trademarks, brands, etc.  EA valued Bioware/Pandemic brands (Presumably Mass Effect, Dragon Age, Mercenaries, and the Bioware and Pandemic names) at $41 million (the annual report does not mention specific IP). Worth noting, however, is that the overall $114 million dollar finite-lived figure also includes core technology (valued at $51 million) and other intangibles (valued at $22 million). Given the pedigree of Bioware and Pandemic, this is understandable, but what isn’t as palatable is the cost of goodwill. 

EA paid $414 million dollars for B/P Goodwill, which is essentially the price paid above the asset value for what amounts to reputation, awareness, and other intangibles. Think about the purchase of a home. You can calculate the cost of the material—wood, glass, appliances—and you can account for the cost of the dirt beneath it. But the view! What’s that worth?  That’s essentially goodwill.

Did EA pay too much for B/P goodwill?  To find out, in a few years we can look for an impairment cost write-down in a subsequent annual report. Impairment cost write-downs are SEC required disclosures that adjust the amount of goodwill that a company carries on its books. It’s the way to get rid of goodwill that’s not-so-good anymore.  In the old days, not-so-goodwill could be amortized over long periods, thus minimizing its impact on a company’s financials, but not any more. Now they wake us up in an annual report like a morning after hangover. 

As an example, EA’s impairment write off for goodwill in 2009 was $368 million dollars, which it attributed to its acquisition of Jamdat (a $684 million dollar purchase in 2006). EA was disclosing a $316 million dollar oops they made when estimating the future income of Jamdat mobile.  That’s big oops.  In fairness, we don’t know if the goodwill EA paid for Bioware/Pandemic was too much, but if it was, it will eventually show up in an impairment write-down a few years from now. 

So why did EA purchase Bioware/Pandemic then? 

EA’s CFO, Warren Jenson, justified the purchase by saying that EA expected to generate $300 million dollars in additional revenue during its 2009-10 fiscal years because of it. Jenson was optimistic about the revenue potential from Bioware’s Star Wars MMORPG, which was in development at the time, as well. Unfortunately, there are a few financial hurdles, including an undisclosed royalty obligation to George Lucas, and a development spend that is rumored to be around $300 million dollars, that could affect that unknown revenue stream. Furthermore, Star Wars Knights isn’t scheduled to ship until EA’s 2012 fiscal year either, so the expenditure may not be complete.  

The point is that there’s a difference between gross and net revenues, which surprisingly doesn’t always factor into the acquisition equation when a publisher gets into a shopping mood. Here, EA not only acquired the assets and goodwill of two companies, but they also assumed an obligation to keep an additional 800 people in salaries and benefits. Add to that the costs (and risks) of other Bioware/Pandemic projects, and you’ve got a substantial burn rate each year, in addition to the net profit required to pay down the acquisition cost. 

I believe a more favorable, more palpable, revenue-motivated transaction was the $18.9 billion dollar Activision/Vivendi merger in 2007. Normally, the fish swallows the guppy, but here it was the guppy (in terms of revenue potential) that swallowed a cash-rich blue whale called Blizzard. 

At merger, Blizzard had a subscriber base of 9.3 million players. They were generating $1.2 billion dollars in annual revenue. Blizzard was laying golden eggs and Activision’s Bobby Kotick was trying to catch the goose.  Creating ways to make money is something that Activision’s CEO is good at, too.  Escapist Magazine retells a story where, during the dot.com boom, Kotick was questioning the value of a speculative web startup. After being chastised for not understanding the Internet business model, Kotick’s response was that “…return on invested capital is the only objective measure of the value of a business.” 1 

That kind of thinking is timeless. Profit, not just revenue, is the ultimate objective of a business, and in contemplating the Activision-Vivendi merger, Activision was hoping to gain a 60% increase in annual revenue. 

So what does any of this have to do with ngmoco? 

If we look at the DeNa/ngmoco transaction from a revenue perspective, we get blurry eyed quickly. For $403 million dollars, DeNa purchased a company that had published only a few dozen iPhone titles and came up with a scheme for connecting iPhone players into a social network. With millions of dollars in venture capital behind them, ngmoco generated $484 thousand dollars in gross revenue in its first year and $3 million in its second year.  In their first year they lost $3 million dollars net. In their second year they lost $10 million dollars. So far, they sound like the highly government-supplemented Amtrak train I ride into San Francisco on occasion. Sure, they’re valuable, but at what cost? 

Things look more precarious when you consider that ngmoco’s strategy transformed in a matter of 24 months from a pay-to-play to a free-to-play model, betting on a social networking scheme called Plus+.  At the time of acquisition, Plus+ had 13.5 million registered users and 50 million connections. That has be worth something, right? 

Here’s a benchmark to consider: In 2009, EA purchased Playfish for $308 million dollars. Playfish’s titles include Facebook’s Restaurant City, Who has the Biggest Brain, and a few of others.  In its 2010 annual report, EA estimates the value of Playfish’s 60 million subscribers at $33 million dollars, which is shown as a component of their Finite-Lived Intangibles.  So logic would dictate that ngmoco’s 50 million connections shouldn’t be worth more. 

Defenders of ngmoco might argue that the metrics used in today’s socially networked world aren’t the same as in traditional video games. In a recent cnbc.com article, writers John Melloy and Julia Boorstin contemplate the perceived overvaluation of Groupon, an Internet coupon startup that’s less than two years old and valued at $6 billion dollars.3  Boorstin reminds us that even in the speculative world of Internet based business valuations, it still comes down to earning potential. Google trades at six times its revenue. A Groupon valuation of $6 billion is ten times the gross revenue it generates today, which is $50 million a month, and investors are wondering how it can be so high. 

ngmoco’s multiple is 134 times its 2009 earnings. 

DeNa’s acquisition of ngmoco can’t be based on a revenue model, at least nothing conceived here on earth and using known mathematical principles.  It defies the laws of the financial universe. Perhaps there’s another reason? Earlier, we hinted that some revenue-based acquisitions are motivated by cost-savings. But we’ll deal with that in the next post. 

For now, let me leave you with this: Pink Floyd’s song ”Money” appears on Dark Side of the Moon, an album that has sold over 50 million copies since it was released in 1973. It’s still one of the best selling albums of all time. It’s been played a zillion times. It’s media-proof, moving effortlessly through time, from vinyl to eight-track to lousy unreliable cassettes to CDs to iTunes.  Dark Side of the Moon will continue to generate revenue and fans into time immemorial.

Pink Floyd has a great revenue model. I wish I could buy them. 

Money…bum ba da dah.

Get back.

I'm all right, Jack.

Keep your hands off my stack.

OTHER BLOG ENTRIES BY DAN ROGERS CAN BE FOUND AT DLR-LAW.COM

-BEST, DAN 

1 EA 2008 Annual Report

2 Dan Gallagher, MarketWatch 

3 CNBC.com 

4 You Tube: Pink Floyd “Money”